Tax Implications of Business Entity Selections
You need to carefully consider the legal structure of your business while starting a new business, bringing in additional investors, or expanding the scope or scale of your existing business. The type of business entity you select will have an impact on your current and future taxation as well as your business operations strategy.
You may need to consider the significant tax implications from a state, federal and international perspective. The entity you choose may also play a major role in future liquidity events. Businesses have the option to operate in the form of:
- Limited or general partnership
- Limited liability company (LLC)
- Sole proprietorship
A critical distinction when it comes to taxation is whether a business entity is a passthrough or non-passthrough.
Sole Proprietorships, Partnerships, LLCs Can be Clubbed as Passthrough Entities
Passthrough entities pass on the income to the shareholders directly. The income is reported through individual shareholder tax returns. This can be better explained through an example. Consider a partnership with 4 equal partners that generates $100,000 of income in a given year.
Each partner receives $25,000 on their tax return which they would have to report in their tax return. Passthrough entities need to take into account deductions, adjustments, and other possible options that can be used for lowering potential tax burdens.
C Corporations & Special Elections are Non-Passthrough Entities
Non-passthrough entities are subject to double taxation. The income generated is taxed at the entity level and then in the hands of the individual shareholder. Taxation at the entity level is known as corporate income tax. This involves a completely different rate structure as compared to personal income tax.
Income is again taxed when given to the shareholders in the form of dividends. However, these need to be qualified dividends. Ordinary dividends are submitted to standard taxation rates that apply to the personal income tax of individuals.
C- and S-corporations are the only non-passthrough entities. However, this doesn’t mean that other entities cannot be taxed as a C-corporation. They would need to make the right election for tax purposes. This means that a partnership can be taxed as a C-corporation if it elects for it.
Factors to Consider During Entity Selection
These are a few factors you should consider when choosing the right entity type for your business:
- Income tax rates (current and anticipated future)
- Projected spread between individual and corporate tax rates
- Potential gains for S-corporation
- Double tax considerations
- Projected distributions
- Future plans for raising capital and outside investors
- Maximum use of shareholder tax basis and business losses
- Desired allocation of income to investors
- Self-employment tax considerations
- 1202 stock gain exclusion opportunities (C-corporations)
- State tax consequences
- Flexibility to convert entity type depending on need
- International consideration
Types of Common Business Taxes
There are taxes that every business needs to pay. Once you have selected the form of business, you would need to pay the following five general types of business taxes:
- Income tax
Every business entity except partnerships is required to file an annual income tax return. Partnerships are only required to file an information return. The form used depends on the type of business organized.
- Estimated tax
Federal income tax works on a pay-as-you-go principle. You would need to pay the tax as you receive or earn income during the year. In general, businesses are required to pay taxes on the income through regular payments made during the year in the form of estimated tax. This includes self-employment tax.
- Self-employment tax
Self-employment tax (SE tax) is a way for individuals working for themselves to contribute to their Medicare and Social Security programs. Typically, entities are required to pay SE tax and file a Form 1040 or 1040-SR (Schedule SE). This is needed only when the net earnings from the entity are $400 or more.
Qualified church-controlled organizations, church, fishing crew members, aliens, state or local government employees, notary public, international organization employees, and foreign governments are subject to special rules and exceptions. This is why you should work with an experienced business formation attorney.
- Employment tax
Employers have responsibilities in terms of employment tax. This includes the various forms you need to file, such as payroll taxes. Federal and state income tax withholding, workers’ social security and Medicare taxes, and federal unemployment (FUTA) tax are all part of employment tax.
- Excise tax
You may need to file and pay for various excise taxes if you are selling or manufacturing products, using certain equipment, products, or facilities, or operating a specific business.
Expert Counsel is Important Before Making an Entity Selection
There are several benefits to passthrough taxation. Stemming from this, non-passthrough taxation has its own set of advantages as well. You should seek expert counsel to make a firm decision since a C-corporation and LLC have their own sets of benefits.
Discuss Your Concerns with a Corporate Lawyer Today
The business formation attorneys at BHM Law Group have decades of experience in helping businesses find the right entity type in regard to taxation and other considerations. Schedule an appointment with a qualified attorney today. Give us a call at 205-994-0902 or fill out our online form.